Growing Pains For Francesca's Holdings

Investors in growth stocks often like to imagine that the sheer growth potential of the company in question can overpower any adverse macro trends that may be impacting the industry. Sometimes that's true, but more often it's the case that these macro trends produce at least some noticeable headwinds. That seems to be the case for Francesca's Holdings (Nasdaq:FRAN), where the oft-cited weather issues in the spring of this year impacted even this small, growing retailer. As a somewhat expensive and heavily shorted retailer, it's not altogether surprising that pre-market trading points to a rough day for the shares.

Traffic Held Up By Weather
Although Francesca's is a pretty fresh concept with a fashion-conscious assortment and a heavy weighting of non-apparel items, weather still did its damage to the company's results. That puts the company in the same boat as Urban Outfitters (Nasdaq: URBN), Chico's (NYSE:CHS), Gap (NYSE:GPS), bebe (Nasdaq:BEBE) and, frankly, almost every retailer, but investors expected more.

Revenue rose 29% and just barely missed the average sell-side guess, but it was how the company got there that mattered. Comp-store sales were up just 2% as reported, and direct sales (internet) contributed all of that with 97% growth this quarter. Flat ex-direct comp growth was below the 4% to 5% range that management had targeted (not to mention the Street), and even the difficult comp created by last year's 16% growth isn't likely to buy the company much leniency.

Margins were notably weaker than expected, and that may be the real problem for investors considering the long-term picture. Gross margin fell about 70bp, while operating income grew 23% to $18 million – about $1 million to $1.2 million (5% or 6%) below most estimates. While the company did meet the EPS target for the quarter, that was largely a byproduct of a lower than expected tax rate.

Will A Different Model Produce Different Results?
Francesca's is definitely pursuing a retail model that stands out from the crowd. Targeting fashion-oriented 18-35 year-old women is nothing new. But what is new (or at least different) is a focus on small stores (the average store is about 1,400 sq ft, or 20% the size of most apparel retail locations), a broad (but shallow) assortment, very short merchandise lead times (16% to 25% of industry averages), and compelling pricing – sometimes 50% or more below retailers like Urban Outfitters' Anthropologie or Nordstrom.

It's also well worth noting that the company offers a different assortment than most of its peers. Apparel is only about 50% of sales, with jewelry, accessories, and gifts making up the remainder. In theory, that should be good for margins and inventory turnover, though this quarter suggests that it doesn't entirely immunize the company from the typical retailer challenges.

I do wonder, though, whether the company will be able to maintain this differentiation for the long haul. Management has talked about a targeted national footprint of 900 stores, more than double the current store base. Will management be able to maintain its rapid-response merchandising and differentiated assortments as it grows larger? Historically, that has been a challenge in this sector.

There are also other issues that bears/shorts cite as problematic for the company. The company sources a meaningful portion of its products from two vendors that were listed as related parties prior to the retirement of Ms. Gill in 2012. There have also been allegations that the company masks markdowns and clearance inventory with store-to-store inventory transfers. If these issues have merit to them (and I'm not convinced that they do), it will eventually show up in the company's margins and cash flow.

The Bottom Line
I'm not going to thump Francesca's for one quarter of disappointing growth. At the same time, though, these shares aren't a slam-dunk value at today's prices. A discounted cash flow model suggests the shares could be overpriced by 10% or more, but then discounted cash flow isn't a great way of identifying quality retail growth ideas. Looking at the company's EV/EBITDA ratio in comparison to its EBITDA growth suggests a much more promising valuation, as EBITDA looks poised to continue growing by more than 20% while the EV/EBTIDA ratio is around 14x. While Francesca's carries many of the typical risks that accompany growth stocks (sustainability of growth, margin leverage, etc.), this looks like a name worth exploring further on this probable post-earnings pullback.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.